governance, political economy, institutional development and economic regulation

Posts tagged ‘Inflation’

February is when the Indian Finance Minister (FM) gets flooded with unsolicited help from well-wishers on how to get his job done of presenting the Union government’s annual budget on the 28th.

This time, the flood is a Tsunami as a consequence of the Delhi state assembly electoral debacle for the BJP on the 10th February. Some fears are imagined. Others are real.

BJP only for the rich?

The BJP has traditionally been a party which works well with the private sector. If viewed through a “zero-sum” filter, this strategy could be perceived as working against the immediate interests of the poor. The classic example is whether electricity supply should be subsidized and if so to what extent and in what manner and whether the private sector’s bottom line concern for profitability can be consistent with an electricity subsidy for customers?

The “Davos mafia”- banks, big business and “growth” fundamentalists are keeping a hawks eye on everything the FM now says to detect signs of his wavering from the hard path of economic reforms announced by him last year. Their expectation is that he will resort to “populism” to placate the poor, with an eye on the nearing state elections in Bihar.

Will Bihar drive the budget?

The BJP cannot afford to lose Bihar. Doing so will surely crack the political invincibility of PM Modi. Some believe it is already dented by an ill-advised, last minute tactic in Delhi of pitting the PM versus Kejriwal, even though it was known as early as January 15th when the elections were announced, that the BJP was unlikely to win. None of this environment is of the FMs making. But it hampers him greatly in being bold, outspoken and visionary on economic reforms- as he has shown an inclination to be.

Statistical flights of fantasy

It does not help that the Indian Statistics establishment has further queered the pitch by an ill-timed release of a new formula for calculating GDP which shows that the UPA government was doing fairly well on growth (6.9%) even in its last year (2013-14) accompanied by reduction in the trend rate of inflation (consumer price index) to 9.5% from 10.2% the previous year.

This raises the bar for the FM in FY 2015-16 to unrealistic levels in growth (>8.5 %?) and possibly also inflation expectations (<5% ?).

The dilemma of the FM is that if he follows a tough approach to economic efficiency he gets branded as heartless and gutless if he doesn’t.

Privatization can soften the subsidy cuts

Privatization of our clunky 277 publicly owned industrial companies; poorly governed 7 public insurance companies and 27 banks is a no-brainer to calm both the heart and the gut of the FM.

The share of publicly owned companies in the Indian stock market capitalization is 48%. If more of them were publicly listed this proportion would increase further.

The capital gains from privatizing- selling at least a 50% plus 1 share in publicly held equity to private investors is sufficient to meet the existing annual aggregate subsidy outlay of around Rs 4 lakh crores (USD 66 billion) for the next five years till 2020 with linked fiscal benefits from tax revenue on higher growth and profitability of these entities. Associated economic benefits like more jobs and employment would be additional.

The FM has the choice of either being fiscally profligate or remaining cautiously courageous whilst perturbing the entrenched interests which feed-off the public sector; a small proportion of unfit employees who would lose their secure jobs; petty contractors who have developed a nexus with public sector contracting authorities and Trade Union leaders. None of these are part of the 300 million poor people of India. Nor are they part of 90% of the workforce, which operates in the unorganized sector as contract labour.

The FM would be well advised to err firmly on the side of “financeable equity”. This objective points him to generate additional revenues to finance selected tax breaks and subsidies.

Here are three suggestions that could set the tone of the FY 2015-16 budget.

Metric of administrative efficiency

First, the FM should announce that this government intends to demonstrate its credentials of being an efficient administration by collecting more revenues from the existing taxes despite offering selective tax relief. This fits well with the already publicized drive against “black money” and the return of undeclared foreign assets of Indian national, residents. This also reassures tax payers that the government intends to retain stability and predictability in the tax regime.

There is nothing like burning ones bridges to bring out the best in oneself. The FM did this last year by taking up the challenge of meeting a 4.1% Fiscal Deficit target for this year and 3.6% of GDP for the next. He should carry through this resolve now without opting for the “lazy” alternative of using the new, inflated GDP data to project a rosy revenue estimate.

Surplus income with small tax payers boosts demand

Second, the FM should demonstrate the government stated preference for “small government”; private finance lead investment and the market.

One equitable way of doing this is to leave more income in the hands of the small tax payer by increasing the income tax-free level from Rs 2 Lakhs per year (USD 3300) to Rs 5 Lakhs (USD 8200). This simple measure takes 90% of the existing assesses (around 29 million in numbers) out of the tax net but impacts only 10% of the revenue.

Pancaked, indirect taxes on consumption (customs/excise; sales tax; municipal taxes) drain 50% of the disposable income of such tax payers in any case, so there is an equity view point also along with the argument for the greater efficiency of a more focused and selective tax effort.

Increase tax revenue equitably and efficiently

India’s tax revenues need to be increased by at least 1% point of GDP but not by continually “milking” the narrow tax base available historically. This approach is neither efficient nor does it build political credibility amongst the tax victims –the salaried middle class. Imposing a new, low tax with a huge tax base as on stock or commodity market transactions and siphoning off a part of the windfall due to the crash in oil prices could be two such option.

Extending income tax to the creamy layer with huge agricultural assets on a presumptive basis is a must. Tax free agricultural income is the easiest refuge for rebranding “black money” as “white”. This loop hole needs to be stamped out.

Agricultural income tax is a tax resource reserved for the State governments. But the Union Government could incentivize States by offering a higher share of GST to states willing to introduce agricultural income tax. This would be in the spirit of efficient, equitable, cooperative federalism.

Third, the Jan Dhan Yojna for financial inclusion has opened 125 million new bank accounts during the last few months. The bulk of these accounts remain dormant. But despite such caveats, this is a good scheme. Recent work, including by Thomas Piketty illustrates that personal wealth is the biggest asset in incremental wealth creation. Why not extend then, albeit in a small measure, the key to wealth creation to the poor also?

Endow the poor for wealth creation

“Dhan” (wealth) is an asset-something you own. It is a pre-condition for wealth creation. Why not open bank or Post Office accounts for the poor also? Of course the poor have no surplus to put into a bank. But the government can fill this gap by depositing Rs 10,000 (USD 164) into each of the bank accounts of all “poor” account holders as a 10 year fixed deposit from which only the interest income would be available to the account holder till maturity. To narrow the ambit and the financial implication of the scheme initially, only poor women and poor senior citizens (the most marginalized of the poor) could be eligible.

Fiscal fundamentalists will deride this measure as irresponsible in an environment when subsidies have to be contained, if not reduced. There are two reasons why their apprehensions are unfounded.

First, the small value of the deposit and its unavailability for withdrawal for 15 long years reduces the attractiveness of the scheme for would be scammers. The annual interest earned of Rs 800 (@8%) per account is not enough to attract fraud but sufficient to keep a genuinely poor person interested in the account as a source of additional income. For the Bank this provides a pool of valuable long term resources for their Treasury operations.

Second, the fiscal outlay, whilst significant, is not unmanageable. The likely pool of “poor” women and senior citizens would be around 200 million. If full coverage is targeted over a three year period, an annual budgetary allocation of around Rs 70,000 crores (only 18% of the existing aggregate allocation for subsidies) would be required. The spread effect, both political and economic, is hugely significant.

In comparison, the Union government alone spends an estimated Rs 4 lakh crores (USD 66 billion or 4 % of GDP) on subsidies. Much of this outlay is either lost in transit to the beneficiary (as in food subsidy- refer to Ashok Gulati, India’s brilliant agricultural economist) or the targeting of the subsidy is so vague (fertilizer and energy subsidies) as to benefit the poor only marginally. A “wealth and income transfer” scheme aided by the Unique Identification mechanism, where available, is likely to be more efficient and effective.

The recent developments in Southern Europe and now in Delhi should convince Mr. Jaitley that “demonstrated equity and inclusion” as a “brand” is in. Citizens do appreciate a tough “reforms” stance. But it must be balanced by effective instruments for income transfers to the poorest of the poor.

A cold Republic Day had FM Jaitley looking dapper under his stylish cap as he snuggled into his overcoat on a rain lashed Rajpath munched nuts and broodingly watched the parade go past.

PM MODI’s OFF-SWING

Was he fleshing out what he would say in his budget speech to the Indian Parliament just one month away? Should he bowl a leg-spin veering sharply left towards equity or an off-swing veering right and towards growth? Around him, on its 66 Republic Day, Modi India was visibly exhilarated celebrating its “off-swing” to the right.

China, possibly stung by this sudden change of events, after the cozy, bon homie of the recent jhula swing on the banks of the Sabarmati, retorted by clasping Pakistan even tighter as an eternal friend. Meanwhile the Greek “loony left”, united with the “loony right” to aspire to become a sovereign debt defaulter with the rest of Southern Europe waiting to follow, should their anarchic tactic succeed.

SOVEREIGN DEBT STRATEGY

Avoiding payment by default is not a new strategy. Latin America similarly exploited the short memories of lenders with serial debt defaults. In contrast Asia, in general and India, in particular, has been very puritanical about its debt obligations, never having defaulted even once in the last forty years, though we came close to it in 1991.

Whilst morally correct, it is unclear if this is a good fiscal strategy. Standard and Poors rates India sovereign debt BBB-, the same as Brazil (which defaulted thrice-1983, 1986 and 1990 in the last 40 years) and lower than Peru-BBB+ (which defaulted twice in 1980 and 1984). From this perspective, debt default is not about “prestige”, “national honour” or about financial rewards. It is merely a game of brinksmanship to be played with the market, if it serves us well.

Was FM Jaitley pondering the merits of doing a Latin America; borrowing recklessly to finance a populist, public investment binge, which “growth-wallahs” are crying themselves hoarse demanding?

Borrowing more is the “soft” option to reforming expenditure since tax collections have dipped. Our borrowing capacity for FY 2015-is limited by a Fiscal Deficit (FD) envelop of 3.8% of GDP, down from the target of 4.1% in the current year. Even the higher FD level severely constrained resources though this constraint remained hidden. The previous UPA-II government put so many non-fiscal barriers on investment-lengthy environmental approvals; land acquisition constraints and contractual inconsistencies which ensured that the project stream froze thereby avoiding additional cash outflows.

The present government is working overtime to unclog the pipes and clear payment arrears. These have built up over time but they do not show up in the budget. Unlike Indian companies, the government follows the “cash” and not the “accrual” accounting system. Both unpaid current liabilities and uncollected current assets are not accounted for in the annual budget. This loop hole enabled the previous government to “sell our future” by collecting arrears whilst falsely showing a robust budget allocation.

GROWTH AND INFLATION

Indian “growth-wallahs” are prepared to risk inflation if it means pushing growth to 7% from the 5.5% it is likely to record in the current year. But the trade off, at the margin, between growth, inflation and jobs is unclear. This is dangerous ground for those living on the edge.

Growth is just a meaningless number for the average citizen. Jobs are welcome of course. But we do not have a “jobs filter” that can assess competing investment. We do not even measure changes in employment through the year. In comparison inflation is an everyday reality which the poor and the urban lower middle class have to battle with daily.

If there is a choice between growth and more inflation, the FM would be well advised to choose containing inflation to below 5% even at the cost of chugging along at a 6% growth level.

PUBLIC INVESTMENT IS HIGHLY INEFFICIENT

The real question is if the domestic and international private sector is unwilling to invest, as for example in Nuclear energy, how can it be desirable for public investment? Clearly, an unhelpful institutional context makes these investments into “lemons”. Unless the root causes of their unviability are addressed, such projects are neither good for the private nor the public sector.

Public investment stoked growth is strongly dependent on the efficiency of public expenditure and the avoidance of “pork”- gold plated projects which fail to provide social returns and jobs. Excessive investment in new renewable energy (a rapidly evolving technology) has precisely this risk.

NO BUBBLES PLEASE

Of course the stock markets will not be enthused by such fiscal caution. But who really gains from the irrational financial exuberance (or despair) of stock markets except a few savvy speculators with deep pockets- not all of them Indian either.

Real Estate is another sector which should be left to lag not lead growth. It is a safe haven for “black money” fed speculation. Five years of cheap money since 2009, high inflation and massive corruption are the drivers of the Indian realty bubble. We have to guard against such bubbles, which consume the savings of the middle class, as in Japan (1980 to 1990) and more recently in the US (2004 to 2012).

LOOKING BACK TO THE FUTURE

One stratagem to inject conservatism into the budget would be to project the FY 2015-16 budget on the growth and revenue numbers which were achieved in 2014-15.

Looking backwards to define the fiscal envelop will further constrict spending estimates. But this would be a useful, albeit unorthodox mechanism, to drive better collection of tax and non-tax revenues and contain “pork” in the spending estimates.

If there are “happy” surprises – revenue exceeding estimates or growth exceeding forecast levels, the surplus generated could be allocated to pre-defined schemes in a supplementary budget later in the fiscal year. Leaving something on the table is good strategy anyway to keep stakeholders engaged and responsive.

Our biggest worry is that populism will trump reason. Subsidies are the elephant in the room of fiscal responsibility. Rationalizing them has become a political hot potato with potentially high political costs. This is why reform needs to be both well timed and appropriately sequenced.

LIMITED REFORM WINDOW

FY 2015-16 is the only reform window available to India for the next four years. If we can’t do it now we never shall. The 2016-17 budget shall be populist since Bihar (2016), UP (2017) and then Rajasthan, Karnataka, Madhya Pradesh and Chhattisgarh go to the polls (2018) followed by National Elections in 2019.

Can we, for starters at least, legislate a cap on subsidies just as there is a medium term trend and cap on FD? We don’t know enough about the extent, substance, nature and social impact of subsidies. Why not make these aspects more explicit by changing the way in which we present the budget documents?

Two subsidy reform steps are immediately doable.

First, making petroleum prices market determined is a no-brainer in the present scenario of cheap energy. This will plug one gap in the subsidy envelop.

Second, rationalize agricultural subsidies which are provided through multiple mechanisms; assured purchase prices for cereals; cheap fertilizer; cheap power; cheap irrigation water; no tax on income and minimal tax on land. Despite these subsidies, rural wages remain low and migration to urban areas is the only options for landless workers and marginal land owners.

These subsidies have only served to create a class of elite “millionaire” farmers; a tiny fragment at the very tip of the 600 odd million strong farming community. Why not use it to better target the poor, rural folk instead? An additional advantage would be that the rural poor have a significant overlap with Dalits and Muslims, neither of which are part of the BJPs traditional support base.

Will FM Jaitley grasp the moment and push through reform or do we have to wait till 2020 for substantive change?

For the small, timid investor and retirees, Provident Funds and Postal Savings were the investment vehicles of choice till 2000. Interest rate liberalization resulted in a progressive decrease in interest levels on long term deposits from 12% to 8.5% per annum.

The reform was sensible. Government could not afford to subsidize the growing gap between what Provident Funds assured investors and what they earned from investments-mostly in Government debt. This strategy also aligned with the objective of growing stock markets by incentivizing small investors to divert their savings to equity.

THE AGED BORE THE BRUNT OF INTEREST RATE REFORM

What the government forgot or disregarded, was that fixed return investments are the natural and appropriate choice for the aged, small investor, who treasures liquidity; safety and simplicity in transactions; characteristics typical of deposits and debt investments. Not everyone can be like Warren Buffet-the Sage of Omaha, who remains an equities guru, at age 83.

Consequently the negative impact of financial reforms has been borne by those who were least capable of doing so- the aged, retiree without an inflation indexed pension. There were two reasons why this happened.

First, high inflation, higher than the nominal interest earned, has reduced “real (inflation adjusted)” returns from interest to negative. If the interest earned is 8% per annum whilst retail inflation is 9% per annum, the investor is earning no “real” return at all. Instead she is paying an “implicit”, additional 1% on her investment to the government as “Inflation Tax”

Second, even on such negative real return, “explicit” income tax is levied at the applicable rate on the nominal return further reducing the real return to the investor and enhancing the “Inflation Tax” paid to the government.

What hurts even more is that dividend income is tax free but interest is taxed. There is a theoretical logic to this asymmetry. Dividends are paid out of the post-tax profit of a corporate. Since tax has already been paid by the corporate, on this value stream, it need not be paid again by the shareholder. Unlike dividend, interest paid by a corporate to a depositor is a “cost” and is set-off against revenue to reduce its taxable profit. Since no tax is paid by the corporate on this value stream the taxman is right to charge tax on interest in the hands of the receiver

Notwithstanding the soundness of this general principle, a solid case exits for exempting interest from income tax.

First, timid, small savers, particularly the aged, have no alternative financial instruments for investing their savings.

Financial pundits may counter that such investors should invest in the risk averaging, Mutual Funds available in the market. But Mutual Funds (MF) themselves tend to shift from equity into debt based investments in a stock market downturn, as happened during 2008 to 2013 (SEBI Annual Report 2013-14). After deducting administration costs, the returns available to MF investors, are not significantly higher that what they could get themselves from deposits.

It does not help that the Indian Stock Market, like other emerging markets, is highly volatile. In 2013 volatility in the Indian stock market was 17% as compared to 11% for the DOW and 12% for the FTSE (Bloomberg-2014). Volatility dissuades aged, timid, small savers from such stock market based instruments, since they have a strong preference for certainty of nominal return.

Second, Inflation management in an open, developing economy, hugely dependent on energy import is tricky. Our record, whilst much better than Latin America, is nevertheless worrisome for an aged person dependent on a fixed income. The government has demurred in offering inflation indexed, real interest rate, saving instruments for retail investors. Possibly the financial risks associated in offering such an investment are considered too high. How then can one expect an aged retiree to bear the inflation risk?

NARROWLY TARGETED TAX BENEFITS

Clearly, the universe of aged Indians are not all under privileged or timid or naïve investors. The cynical could well ask why should the likes of Rahul Bajaj- the illustrious, Indian industrialist, age 76 need special exemptions on interest income or for that matter senior government pensioners or retired senior employees of the formal private sector.

We hold no brief for them since they can look after themselves. In any case it is unlikely that this set allocates a significant proportion of their savings to fixed return deposits. They don’t need to since they have their inflation indexed pensions as a fall back.

Our plea is for the junior level retirees from the formal sector and all retirees from the informal sector. Assuming that 90% of the 62 million aged (5% of population above the age of 65-2011 census) are retirees from informal employment and further assuming that 30% of these-mostly in urban areas- have no income other than from savings, the target beneficiaries would be around 17 million aged people. Most of these may not even be income tax payees. Those who are taxable would probably pay tax at the lowest tax bracket of 10%.

Consequently, the exemption is narrowly targeted at the deserving and is unlikely to result in significant loss of tax revenue.

POLITICALY CORRECT

There is widespread expectation that the FM would raise the tax free income level from Rs 3 Lakh (for senior citizens) towards Rs 5 Lakhs per year. This is a welcome but generalized benefit and not a specific benefit for the 17 million aged, lower middle class, urban retirees – all of whom are voters.

The BJP has been unfairly targeted for being tardy on social protection. The 2014 national election generated heated debate between “callous growth” and “virtuous equity”- a falsely projected zero-sum choice.

Expectedly, the FM will seek to correct this impression in the 2015 budget. But it is tough to implement efficient social protection schemes on a tight budget. Even efficient, rich, developed economies struggle to walk the thin line between providing perverse incentives to beneficiaries to become economic drop-outs and ensuring the adequacy of social security.

In the meantime, please Mr. FM, spare a thought for the average, pension-less, retiree from the informal sector. Save her from the perils of sinking her savings in unregulated “high return chit funds” in desperation, just to make her two ends meet. Exempting interest earned by individuals from Income Tax is a good way of doing this. There is no better “win-win” than this.

We are, for the most part, what institutions make us. Some of us, who are exceptional, disrupt the status quo and change the universe. But generally, such special talents are best in small doses. India has too little of compliance with formal institutional norms and a little too much, of the libertine spirit. Of course, when it comes to informal institutions like caste, religion or class the reverse is as forcefully true.

How can we rework our formal institutions?

What ails most institutions in India is that they lack charismatic leaders and citizens do not see the “value” attached to them. Parliament, for instance, is commonly regarded as a troublesome, distant cousin, who has to be invited to weddings, but from whom most decent folk would run a mile. The Judiciary, even though it has acted repeatedly for the poor and marginalised, is viewed with trepidation, because of the serpentine coils of due process it has wrapped itself in. The Police has traditionally been just plain bad news but now, even the civil bureaucracy, commands scant respect.

One reason for the decline of institutions is that most are closely associated with the legacy of the colonial government. Indeed many are still housed in the same buildings. Most still follow the same rules, which protect the State’s, rather than the citizens’, interests.

But more fundamentally, the conundrum is that India’s Independence struggle was not against the institutions embodying the “Raj”. It was against the foreigners in power at the time. We have retained all the vestiges of the colonial government; a centralized government; symbols of distant, almost princely privilege, for the elected representatives and an under-regulated (albeit also increasingly poorly protected) bureaucracy, trained and organized, to subsume the difference between public and self-interest.

The demise of institutions is a familiar lament. Can it be reversed and what can Budget 2015 do about it? Clearly, the decline is not related to a lack of finances, so change in resource allocation norms provides no solutions. Since 1991, the Budget Speech has become an instrument for announcing big ticket policy changes and this is where it could help. There are three major policy changes for building institutions, which merit inclusion in the Budget Speech of the FM.

First,build the autonomy of Municipal Government. ModiGov is focused on urban areas for economic growth. This is sensible. 700 million (50%) Indians, many of them not yet born, are expected to live in urban areas by 2034. Projectised resource allocations for roads, bullet trains, electricity, water, housing and “smart” cities are being made.

But allocating resources is just the first step. Unless the institution of Municipal Government is restructured, it is unlikely, that the good governance environment required to use these additional resources effectively, can be created.

Local problems need local solutions. But state (provincial) governments are loath to devolve powers downwards. India is a federal democracy. The Union can only persuade and incentivize. It cannot direct state governments to devolve powers.

The FM should use Budget FY 2015 to provide incentives for State Governments to devolve fiscal and administrative powers and functions to municipalities. One option could be a Challenge Fund, with a replenishing, annual corpus of Rs. 10,000 crores (USD 1.5 billion), open to competition amongst the Fifty Four cities, each with a population exceeding one million. Every year, the best five to ten devolution proposals, received from state governments, could be selected. Each selected city would get a direct, long term soft loan, against achievement of milestones, from the Union government via a Special Purpose Vehicle equal to 50% of the average state government grants provided over the previous three years.

This is a “win win” because it enables fund-strapped State Governments to redeploy their funds to other areas, whilst also ensuring more autonomy to dynamic and growth oriented States and cities.

Why is municipal autonomy important? Pan-national schemes are too clunky to be effective. Remote management undermines local participation, ownership and decision making. Meddling in city governance, by state governments, is usually motivated to extract “rent” or some other form of private benefit.

Politically, such devolution makes sense for the BJP, which is a party dear to urban hearts. In fact, rather than go for elections to Delhi State immediately, the Union government should first merge the three municipalities of Delhi into Delhi State, making it the first City State of India. The Union government could retain direct control of the Lutyens Delhi area, where the rich and the powerful live.

Second, is to build the autonomy of regulatory institutions and signal that where a regulator exists the government shall defer to the collective wisdom of that institution. Unless this is done, autonomous regulation cannot be effective. Making regulators effective is key to building investor confidence.

The prime example is the Reserve Bank of India (RBI) which is one of the oldest autonomous regulators.

The positive regulatory experience with the RBI (1934) and then with the Securities Exchange Board of India (SEBI) (1992), encouraged India to expand the area of autonomous regulation for governing Telecommunications (1997); Electricity (1998); Insurance (1999); Anti –Trust/Competition (2002) and Pension Funds (2013).

Our institutional record on managing macro-economic stability is poor. High inflation not only hits the poor the most but also erodes the confidence that the government is in control of the economy. Line managers in government have a hands-off approach to using funds effectively. The government seems complicit in being less than adequately focused on inflation. Public wages are 100% inflation proofed, whilst the poor and employees in the private sector have no such safeguards. Large scale public failures to produce domestic natural resources (oil, gas and coal) in sufficient volume, result in the import of inflation when international commodity prices are high. Poor infrastructure increases the cost of transit. Draconian regulations stifle competition and markets and increase transaction cost.

FM Jaitley needs to clear the air on the institutional arrangements for managing inflation and interest rates. The FM said in his maiden Budget Speech in July 2014 “We look forward to lower levels of inflation…” and asserted the need for “….macro-economic stabilization that includes lower levels of inflation”.

Both objectives have been substantively achieved. The trend is heartening and the FM is entitled to take credit for it. But in the aftermath of this success, there have been discordant voices on interest rates. The RBI Governor has consistently said that windfall benefits from lower international petro and food prices alone should not be the basis for reducing interest rates. The FM has publicly advocated a divergent policy of reducing interest rates to stoke growth.

This public discord is avoidable noise. It perturbs perceptions and muddies expectations. It makes a “dear money” policy less effective. It postpones investments, as entrepreneurs wait for the expected lowering of interest rates. Public unanimity on monetary/interest rate policy issues, with the RBI Governor taking the lead, seems the best way forward.

The Budget Speech provides a good occasion to underline the autonomy of RBI and to give it credit for monetary policy management. The FMs support for an autonomous RBI is bound to be reflected in the relations between other line ministers and their autonomous regulators.

A big gap in the regulatory architecture is the absence of an autonomous regulator for fossil fuels (coal, gas and oil). Coal, gas and oil have consequently suffered from regulatory uncertainty and mismanagement. This is in sharp contrast to the manner in which Central Electricity Regulatory Commission and Telecom Regulatory Authority of India have rationalized the bulk electricity and telecom markets, respectively.

Announcing a time bound plan to legislate an integrated fossil fuel regulator (Federal Energy Regulatory Commission of the US provides a good model), builds on the existing trend to club energy related departments-Coal, Electricity and Renewable Energy have been clubbed under the amiable and eminently qualified Minister, Piyush Goyal. This step would also signal the intention of the government to reverse the politicization of natural resource allocations, whilst also inflation proofing the economy from supply side disruptions.

Third, make the transport sector competitive. Indian Railways (IR) is the life-blood of integrated India. Its declining share in transportation is a result of previous governments bleeding it for political gains. As early as 2001 the Indian Railway Report, chaired by Dr. Rakesh Mohan, laid out a road map for its commercialization. Corporatization is a first step in giving IR the autonomy to compete. Corporatisation will also encourage IR to leverage its considerable assets; use the PPP model aggressively and improve its services. Minister Suresh Prabhu is quick off the block by devolving financial powers to Regional heads to enhance efficiency and transparency in the tendering system, within the existing architecture. But formal restructuring, which requires a bargain to be struck with the unions, would make his job easier.

National Thermal Power Corporation and Bharat Heavy Electricals Limited, both companies listed on the stock exchange, are shining examples of the advantages of corporatization and listing of State Owned Enterprises and their ability to grow, even in a competitive environment. Corporatisation of IR could be followed by restructuring, including possible vertical and horizontal unbundling and a public listing to enlarge its shareholding and expose it to the discipline of the markets.

Bullet trains are a visible symbol that India has arrived. But without the enabling governance structures to sustain such hi-tech assets, today’s advances could easily become tomorrow’s “stranded assets”. It would be a pity if the “smart” cities; the industrial corridors and the bullet trains go the way of toll roads and become pot-holed, one-night wonders. Projects only feed fish. It is institutions which teach a person how to fish.

Success attracts its own supporters. Narendra bhai epitomizes the success of merit and dedication. It is not surprising therefore, that supporters, including erstwhile critics, both national and international, are thronging his doorstep for a darshan.

There are visible signs that the public adulation has not gone to his head. He has shot down an attempt to curry favor with him by BJP governments, by revising the textbooks with a chapter devoted to him as a role model. This is very welcome and good news.

But a big governance test will confront him over the next two months.

Can he support the Finance Minister deliver a “realistic” budget which does not fudge either revenue receipt or expenditure- two favourite tricks of budget managers to fool the public, adopted by the UPA2 in its last budget? Second, can he reduce the fiscal deficit below the level of 4.9% in 2012-13; the last “normal year” data available. The Fiscal Responsibility and Budget Management Act 2003 targeted a maximum Fiscal Deficit level of 2% by 2006. We never achieved that level. The best was 2.7% in 2007. A plan to reach close to this over the next 3 years, by reducing it by 0.5% point every year is sorely needed.

Growth fundamentalists will shout that this is retrogressive. His advisors eager to “kick start” the economy and show dramatic results will advise him to throw fiscal caution to the winds and spend his way out of the economic downturn. But none of the growth fundamentalists can guarantee that “kick starting” growth by public spending actually adds jobs for the poor. Indeed the evidence is adding up to quite the reverse conclusion. Public spending windfalls (as in the Common Wealth Games), line the pockets of the top 1% of Indians, whose business margins soar and of shareholders, whose equity capital appreciates (on which there is no tax at all!). But the impact on jobs is likely to be lagged or minimal.

Narendra bhai’s best bet is to listen to his RBI Governor who is the protector of the poor and the salaried middle class, against the ravages of inflation. The PM should let the RBI Governor set inflation management targets and measures, without restraint. This approach is not sexy, stodgy and reminiscent of IMF style fiscal fundamentalism.

But the short term strategy of boosting the stock market and growth numbers through massive public spending, would be dangerously negligent for an economy, like India, where over 60% of the people are poor, unskilled and live mostly in rural areas and are unable to access jobs in the market economy. For 40% of the people living in urban areas, who are poor, inflation is a bigger calamity, because wages are stickier than prices.

Unearthing black money is being considered as a revenue earning measure, which could painlessly increase the spending power of the government. It also sounds like a “win-win” solution since it responds to the high moral objectives of good governance.

But Narendra bhai, must consider that, Black Money is the lubricant, which keeps the economy ticking today. There are more than 300,000 new, unsold flats clogging the inventory of builders and investors because growth prospects are uncertain. Much of the real estate boom was driven by Black Money fueled speculation, betting on high growth to keep the Ponzi scheme going. But the boom in construction activities did create jobs. A war on black money will directly impact any revival of the listless real-estate market, the economy and jobs. Timing is everything in successful governance reforms. Black money has many negative consequences. But the time to become like Denmark is in a boom, not during a bust.

There are no short cuts to fiscal stability. Cutting back on the governments wasteful recurrent expenditure (which comprises 80% of total expenditure); enlarging the tax base and better tax collection are key priorities.

In this context, good governance, would dictate that tough, unpopular decisions need to feed into the 2014-15 budget:

(1) Target a real reduction in revenue (current) expenditure of 10% over the previous year. Over 50% of the current expenditure comprises interest payments and subsidies. Salaries account for only 8%. As a result, the wage bill is rarely targeted. But just by restructuring Railways into a corporation and the Postal Service into a bank and a corporation, nearly 50% of the wage bill can be taken off the public payroll. Other benefits from corporatization would also accrue.

(2) A majority of central government officials, including in the ministries of coal, power, steel, mines, oil and gas, chemical, fertilizers, civil aviation and telecom spend their time, second guessing, remotely managing or monitoring Public Sector Enterprises. This is a wholly unnecessary job. Transfer the lot of them to the concerned PSE. This will automatically reduce the size of most ministries. Appoint professionals to the Boards of these PSEs, instead of the “shoo-ins” we have today. PSEs are not the “jagirs” of the concerned administrative ministry. “Shoo-ins” are popular today, as Directors of PSEs, because the concerned Minister and the PSE management are comfortable with them. But they do nothing for improving the efficiency of the PSEs.

(3) A second, large chunk of central government employees spend their time administering development schemes implemented by the state governments, but funded either wholly or partly. by the center (central sector schemes). These are wasteful tasks. Hand the task of monitoring such schemes over to NGOs. Send the concerned ministry officials to these NGOs on deputation and get them off the government’s payroll.

(4) Cut back the long chain of command in Ministries. Today a file passes through at least five levels of scrutiny (i) Section Officer(ii)Under Secretary(iii) Deputy Secretary-Director(iv) Additional Secy.-Special Secy.(v) Secretary. This is way too long. The Secretary should be at most the third level dealing with a file and not the fifth.

(5) Filter all incomplete and new projects for their private employment and poverty reduction potential. Fund only the ones with the best “social and economic returns” and review what to do with the “politically sensitive” but wasteful, other projects. Bridges to nowhere and empty but beautifully carpeted roads, are “pork”, not development.

(6) Finally, target fitting the “core” ministries (External Affairs, Defence, Home, Finance, Power, Coal, Mines, Transport, Agriculture, Industrial and Urban Development, Social welfare and Women and Child development), into the space available in the glorious North and South Blocks, which was meant for them. Make space for them, by shifting the PMO into the Rashtrapati Bhawan complex, which is conspicuously vacant. Lease the vacated Bhawans, along Rajpath, to the private sector to earn additional revenue. This will also spare us the drab view of Soviet era, building blocks.

This is the nit-picky governance agenda which the UPA never attempted. A bloated central government, with lots of fingers pointing at each other, is not compatible with Narendra bhai’s ambition and our expectation of effective governance.

Achieving the Fiscal Deficit target for 2014-15 of 0.5% point below the 4.9% actual deficit in 2013-14 by reducing the current expenditure of the central government, is the PMs second test in governance.